Summary of JOIE article ( First View 14 May 2021) by Joyce K. Nabisaalu and Per L. Bylund, Oklahoma State University. The full article is available on the JOIE Website.
“Financial institutions made it easy or at least generally possible for ability to secure capital when not in possession of it by direct ownership and made common the carrying on of business predominantly with borrowed resources.” Knight (1921: 23)
Why don’t developing countries, despite extensive entrepreneurship generate similar levels of economic development like Europe and North America? We describe why this is persistently so based on Frank Knight’s theory, posited in Risk, Uncertainty, and Profit (1921; henceforth RUP). In this paper, we take an institutional perspective to describe the problems embedded in financial institutions of developing countries that fail to provide entrepreneurs with access to finance to grow their businesses. Knight’s discussion in RUP provides a constructive framework for understanding entrepreneurship as uncertainty-bearing and the role of the firm.
Other economists have attempted to provide theoretical and empirical explanations to the unequal economic development from entrepreneurial activity. For example, Schumpeter (1934) theorizes that economic development is created through a process of creative destruction caused by the introduction of disruptive innovations through the expansion of credit. Ridley (2020) argued that innovation thrives under economic freedom to influence economic growth. However, Williamson and Mathers (2011) claim that certain cultures can support entrepreneurship with economic growth without economic freedom. De Soto (2000) observed that the institutional setting in developing economies does not explicitly assign property rights to people’s possessions to be used as collateral when accessing capital.
Our argument emanates from Knight’s conception of capital as material goods and as a ‘fundamental structure of society’ giving the entrepreneur power over economic activities. This position suggests two important hurdles to expanding the extent of entrepreneurship that both relate to the financial institutional setting of developing economies. First, capital constraints limit entrepreneurs’ ability to finance their ventures beyond their personal means – which we expound with Schumpeter (1934). Second, without an institutional structure that properly codifies and secures property rights, the actions of both savers and entrepreneurs are circumscribed – which we expound with de Soto (2000). Our paper combines different perspectives on entrepreneurship and growth in an institutional framework of four hierarchically interdependent levels (Williamson, 2000), described below. Knight’s insights are then applied to explain constraints to entrepreneurial action taking place at specific institutional levels using the case of Uganda, a developing country with one of the highest rates of entrepreneurial activity in Africa (World Bank, 2019).
L1: social norms. This is the top institutional level of social embeddedness level at which culture, norms, and societal values reside; which informs us of the culture history facts and products that influence economic activity (Knight, 1921). Our paper argues that these strong informal institutions determine the family structure, gender roles, and property ownership while imposing biases that conflict with formal rules on lower levels (primarily L2).
L2: the rules of the game. This is the institutional environment with formal institutions such as property rights and laws. Knight viewed formal institutions as unbiased judicial systems, upholding and enforcing property laws and enforcement of contraction for productive business to be carried out. We observe that Knight theorized a free market where political institutions and the market function independently. However, the weak formal institutions and institutional voids in developing countries create high levels of uncertainty in the market, leaving enormous entrepreneurial potential unexploited (Olthaar et al., 2017). This is because political constraints imposed on entrepreneurial activity make breaking out of the circular flow inconceivable while following the rules of the game as is.
L3: banks and the financial system. Financial institutions are ‘middlemen’ accumulating surplus income of individuals desiring to postpone their expenditure and distributing economic resources from capitalists to entrepreneurs forming new combinations. Knight equated capital to the property with the assumption that an entrepreneur may possess individual capital or borrow it when not in possession of it, in exchange for private property owned. However, uncertainty imposed at L2 renders assets possessed by entrepreneurs unable to be used as collateral in exchange for formal capital (de Soto, 2000). Institutional uncertainty compels financial institutions to design costly measures to offset risk which results in high interest rates on borrowing. Moreover, the rules of the game are applied inconsistently due to political influence, even when accessing formal finance from banks in the absence of secure property rights.
L4: level four is the lowest institutional level at which individual action takes place and institutions emerge. Entrepreneurs act in response to their interpretations of the constraints imposed by higher levels to survive in the market. For instance, the red tape and high registration fees make business formalizing unattractive, such that by acting illegally, businesses avoid registration fees and evade tax. While acting informally seems inexpensive for some entrepreneurs, they are excluded from accessing valuable information in associations or alliances, for example on bidding or contracting for formal projects. They are also excluded from bargaining better prices, taxes, interest rates, and access to capital.
Our contribution underscores the difference existing between Knight’s entrepreneur and those in developing countries. Knight’s entrepreneur can gain access to finance by persuading individuals or financing entities of his ability to exercise the function of an entrepreneur. In contrast to entrepreneurs in many developing countries, they typically must have ongoing businesses before they can be considered as borrowers. That means the institutional environment does not make their ability sufficient to secure capital, as Knight (1921) theorized. We observe that institutional levels are vertically interdependent; with higher levels imposing conditions on lower levels even beyond their boundaries. Political and economic institutions are intertwined, monopolized by individuals with political networks and market information. The misalignment imposes conditions that create institutional uncertainty and are detrimental for entrepreneurship. Similarly, financial institutions in developing economies are constrained by uncertainty at higher levels making them unable to effectively support entrepreneurs.
de Soto, H. (2000), The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York, NY: Basic Books.
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Knight, F. H. (1921), Risk, Uncertainty and Profit), London School of Economics and Political Science, Boston, New York: Houghton Mifflin Company.
Olthaar, M., W. Dolfsma, C. Lutz and F. Noseleit (2017), ‘Markets and Institutional Swamps: Tensions Confronting
Ridley, M. (2020), How Innovation Works: And why it Flourishes in Freedom, New York: Harper.
Schumpeter, J. (1934), The Theory of Economic Development, Cambridge, MA: Harvard University Press.
Williamson, C. R. and R. L. Mathers (2011), ‘Economic Freedom, Culture, and Growth’, Public Choice, 148(3–4): 313–335.
Williamson, O. E. (2000), ‘The New Institutional Economics: Taking Stock, Looking Ahead’, Journal of Economic Literature, 38(3): 595–613.
World Bank (2019), Data for Uganda, Sub-Saharan Africa https://data.worldbank.org/?locations=UG-ZG